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The Insular World of the Delaware Judiciary

For anyone focused on Delaware corporate law, the names of the Chancellors at the trial level and the Supreme Court Justices at the appellate level are likely well known. They headline conferences and publish law review articles in top journals. Their opinions are regularly mentioned in the financial press. 

Yet the universe of those knowledgeable about the personalities on the Delaware bench is actually quite small. The lawyers who practice there, the politicians in Delaware who approve them, the occasional blog or periodical that follows them, the academics who follow the decisions all amount to a modest number of people. 

This was apparent from a recent decision by the 9th Circuit. In Rosebloom v. Pyott, No. 12-55516, 8:10-cv-01352-DOC-MLG (9th Cir. Sept. 2, 2014), the panel examined a lower court dismissal of a derivative suit. The court reversed, relying on Delaware state law. In the opinion, the court relied extensively on reasoning provided by one of the Vice Chancellors, Travis Laster. Only the panel was not so familiar with the Vice Chancellor that it was able to correctly identify the jurist. Sometimes he was Vice Chancellor Laster:   


  • In June 2012, in a detailed opinion, Vice Chancellor Laster held in the Delaware case that the plaintiffs had shown demand futility. In his lengthy and thorough analysis of how Delaware law applies to the issue of demand futility, Vice Chancellor Laster expressly criticized and rejected the district court's reasoning. Id. at 357-58. On appeal, however, the Delaware Supreme Court reversed Vice Chancellor Laster solely on the ground that the Delaware plaintiffs were collaterally estopped from pursuing their claims in the Court of Chancery due to the earlier-filed dismissal of the complaint in this case. (citation omitted)

More often, however, he was Vice Chancellor Lasker:

  • Turning to the particularized factual allegations before us, we agree with Vice Chancellor Lasker of the Delaware Court of Chancery, who considered a near-identical complaint, that demand is excused. 
  • We also note that we find persuasive Delaware Vice Chancellor Lasker's explanation in the virtually identical Allergan case in Delaware
  • Applied here, that standard requires reversal. As Vice Chancellor Lasker persuasively explained in his opinion in the Delaware case:
  • Vice Chancellor Lasker's analysis complements the analysis of conscious inaction set forth supra. 
  • [14] Although as we have noted, Vice Chancellor Lasker's decision was vacated by the Delaware Supreme Court on the ground of collateral estoppel, decisions vacated for reasons unrelated to the merits may be considered for the persuasive of their reasoning. 
  • [16]  . . . In these and other ways, the district court abused its discretion. As Vice Chancellor Lasker noted while explaining his disagreement with the district court:
  • [17] Again, we find persuasive Vice Chancellor Lasker's careful analysis of how the district court erred in applying Delaware law: 

This is the type of error that is every law clerk's nightmare. Mistakes can easily creep into personal names or headings for sections of the opinion. Presumably this will be corrected in the final version that appeals in the federal reporter.  

At the same time, however, it demonstrates that, in the federal bench, the Chancellors in Delaware are just one more state court, where the names of the judges are not so well known and, as a result, mistakes like this can occur.  


Berkshire Beyond Buffett: An Excerpt 

(The following is an excerpt from Chapter 8, Autonomy, from Lawrence Cunningham’s upcoming book, Berkshire Beyond Buffett: The Enduring Value of Values; the full text of the chapter, which considers the case for Berkshire’s distinctive trust-based model of corporate governance, can be downloaded free here.) 

. . . Berkshire corporate policy strikes a balance between autonomy and authority. Buffett issues written instructions every two years that reflect the balance. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations. Otherwise, Berkshire stresses that managers were chosen because of their excellence and are urged to act on that excellence.    

Berkshire defers as much as possible to subsidiary chief executives on operational matters with scarcely any central supervision. All quotidian decisions would qualify: GEICO’s advertising budget and underwriting standards; loan terms at Clayton Homes and environmental quality of Benjamin Moore paints; the product mix and pricing at Johns Manville, the furniture stores and jewelry shops. The same applies to decisions about hiring, merchandising, inventory, and receivables management, whether Acme Brick, Garan, or The Pampered Chef. Berkshire’s deference extends to subsidiary decisions on succession to senior positions, including chief executive officer, as seen in such cases as Dairy Queen and Justin Brands.  

Munger has said Berkshire’s oversight is just short of abdication. In a wild example, Lou Vincenti, the chief executive at Berkshire’s Wesco Financial subsidiary since its acquisition in 1973, ran the company for several years while suffering from Alzheimer’s disease—without Buffett or Munger aware of the condition. “We loved him so much,” Munger said, “that even after we found out, we kept him in his job until the week that he went off to the Alzheimer’s home. He liked coming in, and he wasn’t doing us any harm.” The two lightened a grim situation, quipping that they wished to have more subsidiaries so earnest and reputable that they could be managed by people with such debilitating medical conditions.    

There are obvious exceptions to Berkshire’s tenet of autonomy. Large capital expenditures—or the chance of that—lead reinsurance executives to run outsize policies and risks by headquarters. Berkshire intervenes in extraordinary circumstances, for example, the costly deterioration in underwriting standards at Gen Re and threatened repudiation of a Berkshire commitment to distributors at Benjamin Moore. Mandatory or not, Berkshire was involved in R. C. Willey’s expansion outside of Utah and rightly asserts itself in costly capital allocation decisions like those concerning purchasing aviation simulators at FlightSafety or increasing the size of the core fleet at NetJets. 

Ironically, gains from Berkshire’s hands-off management are highlighted by an occasion when Buffett made an exception. Buffett persuaded GEICO managers to launch a credit card business for its policyholders. Buffett hatched the idea after puzzling for years to imagine an additional product to offer its millions of loyal car insurance customers. GEICO’s management warned Buffett against the move, expressing concern that the likely result would be to get a high volume of business from its least creditworthy customers and little from its most reliable ones. By 2009, GEICO had lost more than $6 million in the credit card business and took another $44 million hit when it sold the portfolio of receivables at a discount to face value. The costly venture would not have been pursued had Berkshire stuck to its autonomy principle. 

The more important—and more difficult—question is the price of autonomy. Buffett has explained Berkshire’s preference for autonomy and assessment of the related costs:  

  • We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that [disagreeable] operating and capital decisions are occasionally made. . . . Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly—or not at all—because of a stifling bureaucracy.

Berkshire’s approach is so unusual that the occasional crises that result provoke public debate about which is better in corporate culture: Berkshire’s model of autonomy-and-trust or the more common approach of command-and-control. Few episodes have been more wrenching and instructive for Berkshire culture than when David L. Sokol, an esteemed senior executive with his hand in many Berkshire subsidiaries, was suspected of insider trading in an acquisition candidate’s stock. . . . 

[To read the full chapter, which can be downloaded for free, click here and hit download]


Conflict Minerals Rule Update

The long legal saga of the conflict minerals rule (“Rule”) (discussed here and here) continues. As discussed, the D.C. Court of Appeals largely upheld the Rule, but struck down the requirement that issuers identify their products as being “not DRC conflict free” as being in violation of the First Amendment. After that decision, the SEC filed a petition for an en banc rehearing on May 29, 2014. NAM did not respond to the filing. Thereafter, on July 29 the American Meat case (discussed here) was decided.  

That case found that the Court may apply “rational basis review”—a lower standard of scrutiny—to compelled disclosures even in cases not involving consumer deception. The ruling made express mention of SEC v. NAM, stating that to “the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.”

American Meat is not dispositive on the Frist Amendment issue presented in NAM v. SEC. as the content of the disclosures at issue differ. Still, the case has important ramifications for how disclosures should be reviewed.   

These various legal challenges and decisions leave issuers in great confusion over what their legal obligations are and will be under the Rule. In order to have the opportunity to provide some clarity (or at least to have the opportunity to require the SEC to take further action) the D.C. Court of Appeals on August 28 ordered NAM to file a response to the petition for an en banc rehearing.

According to the Court of Appeals, “Absent further order of the court, the court will not accept a reply to the response.”  

While the legal skirmishes continue, the practical difficulties of complying with the Rule continue to be evident.  While some companies, including Intel and Apple, were able to certify their supply chains as conflict free, others such as Google and J Crew could not make a similar statement. The U.S. government has also acknowledged that it cannot determine the conflict-free (or non-conflict-free) mines and smelters around the world. To date only about 100 smelters have been certified as conflict free by the Electronic Industry Citizenship Coalition. “It’s been a massive effort,” said Julie Schindall, communications director for the trade group. “This whole exercise in mapping the smelters has revealed a lack of knowledge about the metals refining industry.” 

The practical difficulties may add fuel to the legal fire. According to Tom Quaadman Vice President of the U.S. Chamber Center for Market Competitiveness,  “At the end of the day, the conflict minerals rule creates the worst outcome--it has not helped lessen the conflicts in the Congo and creates economic harm in the U.S.”  

And so now we wait for a response from NAM and for further court action. And so it goes. 


Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 8)

We are discussing fee shifting bylaws and the hearing held in Kastis v. Carter. Here is how the court came out at the hearing on the bylaw. 

  • The Court:  In the first instance, picking up with Mr. Grant's last proposal--and the devil is often in the details of these things--but if there is a way to get the plaintiffs and you in agreement that the challenge of the SLC process can be concluded without jeopardy of the bylaw being applied, that seems to me like something you ought to tell me you can work out. Come back to me and tell me if you have worked it out, and we can proceed on that basis. Absent working such an arrangement out, my views on the situation right now lay out sort of in the following way. 
  • We're in a very odd procedural context. I don't think it's appropriate for me to be adjudicating a bylaw, the validity of a bylaw or an as-applied challenge to a bylaw, if that were ever asserted, without it actually being asserted in the pleading in the first instance. So the key thing that has to happen in my mind is the plaintiffs have to make some decisions.
  • Now, they're going to be able to make those decisions in a much better context than when they walked into the courtroom I think today. But the first decision the plaintiffs have to make is do they want to litigate the validity of this bylaw. And if so, they should amend their complaint and say they want to do so and assert such a claim. And leave would be granted that there would not be an issue in this circumstance if that were opposed, but I would expect it would be unopposed. And there would be an amended pleading. 
  • Then the plaintiffs have to make their second decision, which is what type of claim do they want to bring. Do they want to just assert a facial challenge? And you've been told, and I will hold the defendants to their representation, that you can assert such a challenge without jeopardy of the bylaw applying. Or do you want to make a facial challenge as well as an as-applied challenge? And admittedly, the commitment of the defendants is a little squishier there in terms of the reasonable and limited scope of discovery to permit such a challenge.
  • But, ultimately, the plaintiffs have to have the strength of their convictions and decide what kind of claim do they want me to adjudicate on this bylaw. With respect to whether they are willing to bring in a facial challenge alone or a facial challenge, as-applied challenge, and want to move forward on it. And as I indicated, there will be no jeopardy to the bylaw on the facial challenge based on the representation today. The as-applied would appear to be also an avenue to have a challenge without jeopardy, but you'd have to work out the details and make your own judgment--Mr. Hanrahan, I can't make them for you--on what the plaintiffs want to do in that regard. But until such a claim is actually pled, I think it's premature for me to be adjudicating the validity of this.
  • Now, if you assert such a claim in a pleading and amend your pleading to do so, I think we can brief the validity issue, if it's only the validity issue, on a reasonable basis. I think a normal ordinary course briefing type of schedule can bring the issue to the Court's attention. There are, underlying this--and I'm not prejudging anything--many very interesting issues, undoubtedly. This is a for-profit corporation. This is not a non-profit corporation. There are issues of retroactive application in a way that was not considered by ATP that are at issue here because it's purporting to have potential retroactive application to underlying conduct, not just to the universe of shareholders to whom it would apply. I see that as a different issue. There is a bond issue that's different here. There are policy implications about liability to stockholders and for-profit corporations that are at issue here.
  • But all those things would need to be briefed thoroughly; and that has not occurred to date in a way that the Court could intelligently consider those issues. And it hasn't occurred in a way with the defendants even really having an opportunity to respond to most of those arguments because they appeared in this reply brief. So I would--and to be clear, I am sympathetic to plaintiffs' situation, again, absent this last issue that Mr. Grant raised as to whether or not there is a clear path to get this case done in terms of the SLC litigation. If you can work that out and want to proceed on that basis and go down that track, not worry about the bylaw, we'll do that. If you can work it out and you have confidence that you're not in jeopardy in a way you think you can get that work done, that's one track.
  • The other track is you can assert this claim, but if you're going to assert it, you put it in a pleading. And if you're going down the second track and you're not comfortable, you have comfort on the first track; that is, to litigate without jeopardy the SLC issues, I will hold the SLC issues in abeyance while we do the litigation over the facial validity of the as-applied issue on the bylaw. And if you want to go the as-applied route, you can make a motion for expedition, and I think it would be something that should be considered promptly.
  • I'm not sympathetic to the notion--and I think, largely, Mr. Grant, you diffused this, and I appreciate that--of barreling ahead either simultaneously or solely with the SLC-related litigation without sorting out this bylaw issue because I view the bylaw issue to have been a creation of the defendants in the middle of this case to change the rules. And in that context, you know, the rules of the game going forward, as I see, are what I've laid out for you.

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    



Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 7)

Why did the company adopt the bylaw when it did? The record contained this explanation. At the hearing, counsel for the company had this to say: "Just one comment on the timing of the bylaw. While the assertion is that we adopted it in the--the client adopted it in July to apply to them, the timing was that after ATP came out and the Legislature then did not act, only then did our client adopt the bylaw."

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    


Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 6)

The fee shifting bylaw adopted by and challenged in Kastis v. Carter was, apparently, adopted not primarily to have an effect on the federal cause of action. At the hearing, this colloquy occurred. 

  • MR. GRANT: But I think, principally, they would be interested in depositions and ask the question, why did you adopt this bylaw?
  • THE COURT: Okay.
  • MR. GRANT: And I think they would find out that this Kastis litigation is not the principal reason. I think they'll find out that there's securities litigation in the Eastern District of Pennsylvania which is really the central reason for adoption of the bylaw.  
  • THE COURT: I see. Okay.

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    


Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 5)

In Kastis v. Carter, Counsel, therefore, committed that the company would not invoke the bylaw with respect to actions necessary to challenge the bylaw. The bylaw still threatened to grind the case to a halt since the risk remained that efforts to persue the challenge to the decision by the Special Committee would trigger application. Here as well, counsel for the company took the issue off the table: 

  • Mr. Grant: But what prompted me to stand up is I have a suggestion for us all to consider for a different direction in which to go. Going back to my initial comment that we think the next step should be resolving the SLC motion to dismiss, we can make the same representation again with let's call it reasonable discovery, that we will not enforce the bylaw against plaintiff for time spent on the defense side for reasonable discovery, briefing and argument on the SLC motion to dismiss. And I think that then protects them.   

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    


Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 4)

Plaintiffs challenged the fee shifting bylaw adopted by the board of Hemispherx. The trial court was concerned that a challenge to the bylaw did not appear in the complaint.  

Counsel for Plaintiffs nonetheless sought a decision by the court on the validity of the bylaw. In part, they asserted that challenging the bylaw, including the process of drafting and submitting an amended complaint, could itself be a continuation of the litigation sufficient to trigger the imposition of fees should shareholders not prevail. Counsel for the company, however, strategically took the issue off the table.  

  • THE COURT: Is the company prepared to commit--and we can take it in stages--one, to allow--whether we put it in a pleading or not, we'll get to that separately--litigation over the facial validity of a bylaw to occur without seeking to impose, if it goes unfavorably for the plaintiffs, the application of the bylaw against the plaintiff--anybody--the plaintiff, plaintiff's counsel, anybody?
  • MR. GRANT: For that phase of litigation, yes. 

Said another way: 

  • THE COURT: Okay. Now let me take it to the next step. How about will it apply to anybody for purposes of making a factual record and bringing on a claim--a Schnell claim, basically--that it may have been adopted for an improper purpose? Is the company prepared to commit that it won't seek to apply the bylaw in that circumstance if it works out for the plaintiff?
  • MR. GRANT: When you say "anybody," you mean a different plaintiff?
  • THE COURT: No, no, no. In this case. In this case. Let's assume Mr. Hanrahan amended his complaint, sought declaratory judgment that the bylaw is invalid, asserted a breach of fiduciary duty claim or whatever claim he wants to bring saying it was adopted for an inequitable purpose. I hear you saying that on Count I, declaratory judgment, facially invalid, the company is not going to enforce this bylaw to litigate that issue. I appreciate that concession, if you will. What I'm asking you now is for purposes of Count II, if he litigates over whether it was adopted for an inequitable purpose, takes discovery surrounding the circumstance of the adoption of the bylaw, litigates that issue, is the company prepared to commit or not that it will seek to enforce that bylaw against anybody? If you don't have a--look, I'm not going to like tear something out of you you're not prepared to commit, but it would help me sort through things if I knew your position on that.
  • MR. GRANT: Understood, and I appreciate that. The company's position on that question, Your Honor, is if the amount of discovery required is reasonably cabined so we're not talking about 20 depositions, then, yes, we will commit not to seek to apply the bylaw against plaintiffs for an as-applied or is-it-equitable type of challenge. Now, if--I don't think they need 10 or 20 depositions, but if it became a huge discovery program, I'd like the opportunity to consult with our client before giving a firm answer.
  • THE COURT: I appreciate that. Thank you.

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    


Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 3)

We are discussing fee shifting bylaws.

Perhaps the most interesting bylaw involves the one adopted by the board at Hemispherx (and challenged in Kastis v. Carter).  The bylaw was adopted after litigation had been filed by shareholders.  The bylaw provided: 

  • (a) In the event that, after the date of adoption of this Section 5.7, (i) any current or former security holder of the Company (the “Claimant”) who initiates, asserts, maintains or continues against the Company any litigation, claim or counter-claim (“Claim”) (each such Claimant, together with any other person who joins with the Claimant, offers substantial assistance to the Claimant, or has a direct financial interest in any Claim, being herein collectively referred to as the “Claiming Party”) against the Company or against any current or former director, officer or security holder (including any Claim purportedly filed on behalf of or in the right of the Company or any security holder) arising in whole or in part out of any Internal Matter (as defined below), and (ii) the Claimant does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the Company and any such current or former director, officer or security holder for all fees, costs, and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the Company and any such current or former director, officer or security holder have incurred in connection with such Claim. 

The provision, therefore, applied to the instigation of a claim, but to the maintenance and continuation of a claim.  The provision, therefore, on its face applied to the litigation against the company had had already been initiated by shareholders.  

The provision also made explicitly clear that the fee shifting bylaw applied to causes of action under the federal securities laws.  The bylaw defined an internal matter as follows:   

  • For purposes of this Section 5.7, the term “Internal Matter” shall mean and include (i) any derivative action or proceeding brought on behalf of or in the right of the Company, (ii) any action asserting a claim of breach of a fiduciary duty owed by any director, officer or other employee of the Company to the Company or the Company’s security holders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, (iv) any action asserting a claim arising pursuant to any provision of the federal securities laws, and any regulation promulgated pursuant thereto, or (v) any action asserting a claim governed by what is known as the internal affairs doctrine. 

Shareholders in a derivative suit in Delaware challenged the bylaw, arguing that it was "invalid, inapplicable and unenforceable."  They asserted that the provision threatened to impose costs on counsel. 

  • The Bylaw imposes liability not only on stockholders but also on anyone who offers substantial assistance to the stockholders or who has a direct financial interest in a claim. Therefore, the Bylaw threatens Plaintiffs’ counsel, who are prosecuting this case on a contingent basis, with liability for Defendants’ fees and costs.

To the extent that the court declined to do so, counsel asked that an order be granted "voluntarily dismissing this action" and that counsel be allowed to withdraw.  Moreover, any further effort to "continue" the litigation would create the "threat of retroactive liability for all defense costs since the commencement of the action on June 18, 2013."

At a hearing on the subject, counsel noted that any continuation of the litigation while the bylaw was in place potentially threatened its clients with the imposition of fees.  As counsel stated: 

  • But right now, we can't do anything about that, because if we do anything, under this bylaw, it subjects our clients to liability that the defendants say they've incurred hundreds of thousands of dollars of fees so far. And so while we were carrying out the process that Zapata mandates for dismissal of a derivative case in a demand excused context, this bylaw comes in and, basically, we can't continue with the Zapata process. We can't do anything because there would be crippling financial liability that would attach to our clients, including a bond requirement and liability for all defendants' legal fees and expenses if plaintiffs continue or maintain this litigation and do not obtain a judgment on the merits essentially for all the relief sought. 

Moreover, counsel asserted that the standard in the bylaw for shifting fees was met even where shareholders were successful.   

  • I've litigated many cases on behalf of stockholders in my 36 years at the bar, and very few result in a judgment on the merits. Fewer still a judgment on the merits for plaintiffs. And of those few, my firm has had some success in obtaining actual judgments on the merits in favor of stockholders. But even in that handful of cases, we would not have met the success standard of the Hemispherx bylaw. 

Where these types of bylaws existed, shareholders would not bring suit. 

  • if a bylaw may apply to these plaintiffs, they cannot -- and virtually no stockholder can [maintain an action], particularly in a derivative case. You have no direct interest in any recovery and your indirect interest is going to be minimal. That's why there are derivative cases, is because the Delaware courts have recognized that, otherwise, people would not bring a case challenging a corporate action because they wouldn't have a sufficient economic interest. It's only if you can bring it on a representative basis. 

Moreover, counsel indicated that the act of challenging the bylaw arguably triggered the provision and potentially subjected shareholders to the imposition of fees.  We'll continue this discussion in the next post.  

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    


Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 2)

What are some attributes or variations among the different fee shifting bylaws?  

First, the numbers have been relatively modest, so far.  

Second, they have not been limited to Delaware corporations. At least one has been put in place by a Maryland corporation. See Current Report, American Spectrum Realty, Inc., July 24, 2014 (adding bylaw that would "provide for fee-shifting with respect to certain types of litigation brought against the Company and/or any director, officer, employee or affiliate where the claiming parties do not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought."). The bylaw is here.    

Another has been inserted into the bylaws of a Utah corporation. See Current Report, NATURE’S SUNSHINE PRODUCTS, INC., August 28, 2014 ("The sole purpose of the Restated Bylaws is to add an additional section to the Bylaws which requires that any unsuccessful shareholder litigant in a suit against the Company reimburse the Company for all of the Company’s litigation costs, including reasonable attorney fees.").  

Third, they have appeared in limited partnership agreements and registration statements. See Form S-1, Viper Energy Partners LP, August 13, 2014, at 111 ("If any person brings any of the aforementioned claims, suits, actions or proceedings and such person does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then such person shall be obligated to reimburse us and our affiliates for all fees, costs and expenses of every kind and description, including but not limited to all reasonable attorneys’ fees and other litigation expenses, that the parties may incur in connection with such claim, suit, action or proceeding."); see also Form S-1, Cone Midstream Partners, LP, August 25, 2014, at 47; Prospectus, Westlake Chemical Partners LP, at 143.

Fourth, they have, in one case, appeared in the context of a coversion from an LLC to a corporation. See e.g.Form S-1, Townsquare Media, LLC, June 24, 2014.  

For other examples, see Lannett Company, Inc., Current Report on Form 8-K, July 17, 2014; Echo Therapeutics, Current Report on Form 8-K, June 27, 2014 (the bylaw is here); The LGL Group, Current Report on Form 8-K, June 17, 2014; and Biolase, Inc., Current Report on Form 8-K, June 30, 2014.  


Welcome the 2014-15 Blog Members

The Blog would like to welcome the 2014-15 Race to the Bottom team!


Back Row (L to R): Andrew Hansen, Aaron Witucky, Andrea LaFrance, Meredith Spears, Robin Alexander, Jenna Brunett, Riley Combelic, Thomas Walton, Patrick Rohl, Jessica Bullard, Rafay Asrar

Front Row (L to R): Shannon Moran, Rachel Wright, Nadin Said, Gabrielle Palmer, Christie Nicks, Jenna Disser, Melissa Colborne



Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 1)

In ATP Tour, Inc. v. Deutscher Tennis Bund the Delaware Supreme Court upheld a very broad bylaw that allowed for the shifting of fees in the context of a non-stock company.  

Although a non-stock company, it did not take long before the bylaws began to appear in the context of for-profit stock corporations. The case came out in May. By July, companies were adopting the bylaws. As a memorandum from Wachtell back in July described: 

  • To date, we are aware of two Delaware corporations that have adopted fee-shifting bylaws applicable to stockholders. One (The LGL Group, Inc.) adopted its bylaw a week before the Delaware State Senate passed Joint Resolution #12, and another (Echo Therapeutics, Inc.) did so a few days after the Senate acted. In addition, another company (Townsquare Media, LLC) has filed a preliminary registration statement with the Securities and Exchange Commission, indicating that it is considering including a fee-shifting provision in the certificate of incorporation it plans to adopt when it converts into a Delaware corporation in connection with its pending initial public offering. 

Since then the numbers have increased, with around a dozen or so companies (some of which are partnerships) adopting these types of provisions.    

The bylaws are, typically, broadly drafted. They apply not only to current or prior stockholders but also anyone who joins, offers substantial assistance to, or has a direct financial interest in, any claim. Likewise, they do not shift fees only upon a dismissal. Instead, the fee shifting provision typically applies to anyone who fails to obtain "a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought." Thus, shareholders do not have to avoid dismissal to avoid paying fees; they have to win the case.  

They also are not typically limited to cases involving fiduciary duties or other claims that can be characterized as matters of "internal affairs." Instead, it applies to any claim (by a shareholder/former shareholder). Presumably, therefore, the language sweeps in causes of action under the federal securities laws.  

Where fees shift, shareholders are "obligated jointly and severally to reimburse the Company and all such directors, officers, or employees for all fees, costs and expenses of every kind and description."

As one company described: 

  • The principal amendments to the Bylaws provide for the shifting of litigation expenses in intra-company litigation, to the fullest extent permitted by law, to an unsuccessful plaintiff who does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, and that a plaintiff in such litigation is required to pay all of its own litigation expenses, as well as all fees, costs and expenses of the Company’s directors, officers or employees, and will not be entitled to recover such litigation expenses from the Company, regardless of whether the plaintiff is successful. 

See Current Report, Portfolio Recovery Associates, July 31, 2014. The bylaw is here.  

Nonetheless, variations are beginning to develop. We'll look at some of the attributes in the next post. We'll also look at the one case, so far, that involves a challenge to a fee shifting bylaw.    


Gatekeepers, Enforcement, and the SEC  

Public dissents in enforcement cases by commissioners are unusual. Enforcement cases are approved by a non-public vote. The drafting a dissenting statement, therefore, means that the approved action was not unanimous. Moreover, given the workload of the commissioners and their staff, they are unlikely to draft dissents every time they disagree with the outcome of a decision.  

So we note with interest the dissent by Commissioner Luis A. Aguilar, in In re Blodgett & Keyser, Exchange Act Release No. 72938 (admin. proc. Aug. 28, 2014). The dissent focused on settlement with Mr. Keyser, a CPA and former CFO, describing it as a "wrist slap at best." See Id. ("Given the egregious conduct that [the CFO] engaged in at [the company], the Commission’s settlement, which lacks fraud charges or a timeout in the form of a Rule 102(e) suspension, is a wrist slap at best.").  

Disagreements over the application of the facts to the law are likely to be common. The thrust of Commissioner Aguilar’s dissent, however, was over a broader issue, the possible pattern with respect to enforcement.  

  • Beyond this particular matter, I am concerned that the Commission is entering into a practice of accepting settlements without appropriately charging fraud and imposing Rule 102(e) suspensions against accountants in financial reporting and disclosure cases. I am also concerned that this reflects a lack of conviction to charge what the facts warrant and to bring appropriate remedies. 

He backed up the assertion with statistics: 

  • The statistics on financial reporting and disclosure cases and related Rule 102(e) suspensions reflect a troubling trend. In fiscal year 2010, the Commission brought 117 financial reporting and disclosure cases against issuers and individuals, and imposed Rule 102(e) suspensions in 54% of those cases. In 2011, the number of financial reporting and disclosure cases against issuers and individuals brought by the Commission fell to 86, and the Commission imposed Rule 102(e) suspensions in 53% of those cases. In 2012, again the number of similar cases brought by the Commission fell, this time to 76, and the Commission imposed Rule 102(e) suspensions in 49% of those cases. In 2013, the Commission brought only 68 similar cases, and imposed Rule 102(e) suspensions in only 41% of those cases. 

His conclusion? "These declining numbers reveal a departure from the Commission’s efforts to keep bad apples out of the securities industry, and this puts investors and the integrity of the Commission’s processes at grave risk."

The SEC has a number of enforcement priorities. The Commission has, for example, toughened its approach to enforcement by sometimes obtaining actual admissions from those settling cases. But the risk of admissions, while imposing a meaningful price for bad behavior, is not likely to have a significant deterrent effect. Imposing meaningful penalties on gatekeepers, on the other other hand, is likely to have  a deterrent effect. That, it seems, is the primary thrust of the position taken by Commissioner Aguilar.   


The SEC and Administrative Proceedings (Part 5)

We are discussing some of the issues raised by Peter Henning in his DealBook column, The S.E.C.’s Use of the ‘Rocket Docket’ Is Challenged. The article examines concerns that have been raised about the use of administrative proceedings by the SEC.  

As the DealBook article notes, the challenges to the use of administrative proceedings ("APs") have continued.

The SEC charged George Jarkesy with violations of the securities laws back in 2013 and issued an order instituting administrative proceedings. Sometime before the AP, the SEC entered into a settlement with some of the parties involved in the alleged wrongdoing. See In re John Thomas Capital, Exchange Act Release No. 70989 (admin proc Dec. 5, 2013).  

Shortly before the administrative proceeding was set to begin in February 2014, Jarkesy (the "Plaintiff") filed suit in federal district court seeking emergency injunctive and declaratory relief to prevent the SEC from going forward with the AP.  

Plaintiffs alleged that they were "denied their fundamental rights of due process, jury trial, equal protection." The complaint also asserted that the SEC had prejudged the case and could not, therefore, act as a neutral decision maker. According to the complaint:  

  • The fundamental precept of due process--fully applicable to agency adjudications--is a fair hearing before an objective and fair tribunal. By numerous of its actions, the SEC has stripped the AP process of minimum standards of fairness, thereby eliminating all possibility of a fair hearing. Then by publishing its extensive findings and conclusions against Plaintiffs, finding them guilty--in advance of the adjudication and without permitting plaintiffs to present any evidence or defenses--the SEC has removed all doubt about its ability to serve as a fair tribunal.    

The district court, however, declined to issue the relief sought and ultimately dismissed the action. The court found that, as a district court, it lacked jurisdiction. As the opinion reasoned:  

  • The statutory and regulatory regime under which the SEC’s Enforcement Division brought the instant matter against the plaintiffs precludes this Court from exercising subject matter jurisdiction to hear the plaintiffs’ claims. The Exchange Act, which the plaintiffs are accused of violating, provides that “[a] person aggrieved by a final order of the [SEC] . . . may obtain review of the order in the United States Court of Appeals.” 15 U.S.C. § 78y(a)(1). This statute presents two insurmountable obstacles for the plaintiffs’ case in this Court: first, no final order has yet been entered by the SEC, which raises substantial questions about the ripeness of this action for review; and, second, even were this action ripe, federal court review must take place in one of the courts of appeals.  

After discussing the absence of a final agency action (and the relevant exceptions), the court noted that, in general, trial courts lacked jurisdiction to hear cases where the statute vested jurisdiction in the court of appeals. See Id. ("Courts interpreting Free Enterprise have similarly found that where a statute provides an agency the first opportunity to review a claim before appeal to a Court of Appeals, the statute deprives the District Court of jurisdiction.").  

Thus, the claim of prejudgment had to be raised at the court of appeals. Id. ("In sum, the statutory regime embodied in the Securities Act sets forth an exclusive mechanism for the plaintiffs to pursue their claims: first, before an ALJ, then before the SEC’s Commissioners, and finally, if necessary, before a Court of Appeals. To the extent that the plaintiffs believe their cause has been prejudged by the SEC’s Commissioners, they may seek review, if necessary, before the Court of Appeals, but the statute leaves no room for this Court to provide them the relief they seek.").   

As for the precedent set by the Gupta decision, the court had this to say: 

  • As the Court indicated at the TRO hearing, the plaintiffs’ reliance on Gupta is questionable in the wake of Altman v. SEC, 687 F.3d 44, 45 (2d Cir. 2012), which applied Thunder Basin in affirming a District Court’s decision that it did not have subject matter jurisdiction over a constitutional challenge to an ongoing SEC administrative proceeding. In any event, the Court finds the controlling precedent in this Circuit to support only one outcome in this case: namely, dismissal. 

The AP with respect to Jarkesy did take place. The ALJ hearing the case has requested additional time to issue the opinion. See ORDER EXTENDING DEADLINE FOR FILING INITIAL DECISION, In re John Thomas Capital Management, Exchange Act Release No. 72841 (admin proc. August 13, 2014). Jarkesy, in the meantime, has lodged an appeal.  

The appeal has the potential to provide very strong guidance in this area. To the extent that the court of appeals reverses, the SEC will likely be challenged more frequently for the choice of forum. On the other hand, to the extent the D.C. Circuit affirms the district court opinion it will likely dampen the incentive to file these actions.  


The SEC and Administrative Proceedings (Part 3)

We are discussing some of the issues raised by Peter Henning in his DealBook column, The S.E.C.’s Use of the ‘Rocket Docket’ Is Challenged. The article examines concerns that have been raised about the use of administrative proceedings ("AP") by the SEC.  

The decision in Gupta v. SEC held out the possibility that challenges to the SEC's choice of forum could be successfully maintained. It wasn't long after the decision came down that Egan-Jones, the rating agency, likewise lodged a challenge to the SEC's decision to bring an AP. The Company challenged the absence of safeguards in the administrative process and also viewed the choice of forum as unfair and unsupported by a rational basis. As the complaint stated:   

  • This Enforcement Action, if allowed to proceed in an administrative forum, would deprive both Egan-Jones and Mr. Egan of their right to a jury trial and other critical procedural safeguards available in our judicial system, including, but not limited to, the ability to mount defenses and obtain evidence in support thereof relating to the unfair and disparate treatment of Egan-Jones by the SEC, with no rational basis, and evidence relating to the motive for the SEC to do so; the SEC’s improper motive in bringing this action including the denial or marginalization of Egan-Jones’ content and voice in the marketplace; and the maintenance and continuation of the status quo conflicted issuer-paid ratings model in contravention of Congressional direction.

Egan-Jones viewed itself as singled out but the case involved a different set of facts than those at issue in Gupta. Gupta could point to other similar cases that raised concerns over disparate treatement. As the court stated in that case: 

  • A funny thing happened on the way to this forum. On March 11, 2011, the Securities and Exchange Commission (the "SECI" or "Commission")--having previously filed all of its Galleon related insider trading actions in this federal district--decided it preferred its home turf. It therefore issued an internal Order Instituting Public Administrative and Cease-and-Desist Proceedings (the "OIP") against Rajat K. Gupta. 

Egan-Jones also alleged disparate treatment. The disparate treatment, however, was that it was the only rating agency singled out for administrative action in the described circumstances. See Egan-Jones Complaint ("While the SEC targets Egan-Jones for alleged infractions which have not affected a single rating or investor, the SEC has not suggested that it will ever take any real, proportional action against the large issuer-paid firms for issuing profitable inflated ABS and CDO ratings which brought about America’s economic crises.").   

The SEC sought dismissal, primarily by arguing that the district court lacked jurisdiction (the appropriate forum was the court of appeals) and that there was no final agency action under the APA. Egan-Jones contested the motion (to which the SEC replied), but there was never a resolution of the issue. The plaintiffs voluntarily dismissed the action.  


The SEC and Administrative Proceedings (Part 2)

We are discussing some of the issues raised by Peter Henning in his DealBook column, The S.E.C.’s Use of the ‘Rocket Docket’ Is Challenged.  

In any event, the limits on discovery, the fact that ALJ decisions are appealed to the Commission, and the quick pace for a decision have long been attributes of the administrative process. Yet suddenly, it seems, parties have been challenging the SEC's decision to bring an administrative proceeding much more frequently.  

What are the reasons for the challenge? For one thing, Dodd-Frank made the proceedings less attractive to some litigants by increasing the SEC's authority to seek penalties. As we previously described:   

  • Dodd-Frank, however, took away one of the disadvantages to administrative proceedings. See Section 929P of Dodd Frank (amending Section 21B(a) of the Exchange Act). The Agency can now seek penalties in the proceedings against persons who are not associated with regulated entities. Indeed, the administrative proceeding against Gupta is the first to seek penalties under this authority. See Remarks at SIFMA’s Compliance and Legal Society Annual Seminar, Director of Enforcement Robert Khuzami, March 23, 2011 (case against Gupta was “the first use by the SEC of its new authority under Dodd-Frank to obtain penalties in an Administrative Proceeding against persons not associated with a regulated entity.”).  

Another reason may be that judges are more willing to entertain claims about choice of forum than they were in the past. Certainly, the incentive to challenge the SEC for its choice of forum received significant impetus from the efforts of Rajat Gupta.  

Gupta was subjected to an SEC AP and he challenged the use of the administrative forum. What made the case stand out was that the district court allowed the challenge to go forward. See Gupta v. SEC, 796 F. Supp. 2d 503 (S.D.N.Y. 2011). The main basis for the challenge was not discovery, neutrality or quickness, but an alleged equal protection violation. Gupta essentially asserted that he was singled out, that actions against other individuals had been brought in district court. See Id. (“The Complaint alleges that the SEC intentionally, irrationally, and illegally singled Gupta out for unequal treatment in a bad faith attempt to deprive him of constitutional and other rights, in retaliation for his strenuous assertion of his innocence.”).   

We blogged on this case extensively. Posts are here, here, here and here. The decision held the potential of subjecting SEC staff to depositions and other discovery while they were seeking to bring a case against Gupta. In light of the decision, the SEC terminated the administrative proceeding. For a discussion of possible reasons why the SEC chose to bring an administrative action against Gupta, go here.  

Given the discretion usually assigned to an agency to decide whether and where to bring a proceeding, the decision was analytically weak. Nonetheless, it was easy to predict what would follow. As we noted:

  • As a result of this reasoning, there are two likely outcomes. First, the number of parallel suits will increase dramatically. Why not? You can obtain discovery against the agency and explore the staff's motivations for bringing the relevant administrative proceeding. Even if the case is ultimately a loser, its possible that it will make available plenty of information useful in the administrative proceeding (and the eventual appeal to the United States Court of Appeals). The increase in the number of suits will require the SEC to reallocate attorneys from the Division of Enforcement to the Office of the General Counsel, the office that defends actions filed against the Commission. Thus, the SEC will have to reduce resources used to investigate and enforce the securities laws. 

And, in fact, a number of actions challenging the SEC's choice of forum have been lodged, as Peter's article notes. 


The SEC and Administrative Proceedings (Part 1)

Peter Henning wrote an interesting piece over at DealBook on the SEC's use of administrative proceedings in place of actions in federal district court.  See The S.E.C.’s Use of the ‘Rocket Docket’ Is Challenged.  These hearings occur not before an Article III judge but are heard by an administrative law judge who is employed at the Commission.   

Peter noted a number of differences between administrative proceedings and proceedings in federal court. Administrative proceedings have shorter time fuses (anywhere from 120 days to 300 days), allow for less discovery (he stated that discovery is "largely limit[ed to] the evidence to whatever the agency gathered during its investigation"), and "there is no neutral judge involved."  The article also noted a number of parties that were challenging the SEC's use of administrative proceedings.  

The article provided a catalyst for discussing the use of administrative proceedings.  A list of these proceedings can be found here.  Administrative practices are subject to the SEC’s rules of practice, which can be found here.

A number of the criticisms listed in Peter's piece are really simply acknowledgements of differences between administrative and court proceedings that could just as easily have been praised.  Thus, the title to the piece refers to the SEC’s “rocket docket.”  Administrative proceedings in general must be completed no later than 300 days after filing.  See Rule 360.  While this can, in some cases, create an uncomfortable time crunch, it is, for the most part a matter that ensures parties that SEC allegations will not remain unaddressed for protracted periods of time.  

As for the reduction in discovery, parties still can subpoena documents (see Rule 232) and in at least some cases depose witnesses.  See Rule 233 (requiring a motion for approval of depositions)  Nonetheless, the proceedings do provide for less discovery.  The trade off is a reduction in costs.  It is not uncommon for court proceedings to be criticized because of the high cost of discovery.     

As for the concern over the absence of a “neutral” decision maker (the administrative law judges are employees of the Commission), the issue is structural and longstanding.  Administrative law judges are typically hired and paid by the agency where they are making decisions.  Nonetheless, steps have been taken to ensure that they can make decisions in a manner that is independent of the agency.  As the Manual for Administrative Law Judges provides: 

  • To insure independent exercise of these functions, the ALJ's appointment is absolute. The ALJ is not subject to most of the managerial controls which can be applied to other employees of a federal agency. For example, ALJs are not subject to performance appraisals, and compensation is established by the Office of Personnel Management, independent of agency recommendations. Furthermore, the agency can take disciplinary   Id. at 2-3.  

It is true that appeals from the ALJ go directly to the Commission, creating a situation where the Commission staff is arguing positions before the agency that approved the case in the first instance.  Nonetheless, the safety valve for concerns over this structure is the right of appeal to the US Court of Appeals (usually the well versed and knowledgeable DC Circuit, a court that has not been particularly deferential to SEC decisions). Ultimately, any decision made by the Commission, therefore, will be examined by an Article III Court for error.


Morrison, the Second Circuit, and the Reverse Effects Test: ParkCentral Global Hub Limited v. Porsche Automobile Holdings (Part 2)

We are discussing the Second Circuit's decision in ParkCentral Global Hub Limited v. Porsche Automobile Holdings, a case that effectively created a "reverse effects test" that was contrary to the Supreme Court's analysis Morrison v. National Australia Bank.   

In ParkCentral Global Hub Limited v. Porsche Automobile Holdings, the court addressed the full implications of the reasoning in Morrison.  The case involved foreign defendants, foreign companies, foreign conduct, and losses based on price movements of foreign securities.  Nonetheless, the transaction was alleged to have occurred in the United States.

The court had to squarely confront whether in fact conduct and the nature of the action were irrelevant to the analysis as Morrison indicated.  The court concluded that while the transaction had to be domestic or involve a listed security, such a condition was necessary but not sufficient.  Id.  ("we conclude that, while a domestic transaction or listing is necessary to state a claim under § 10(b), a finding that these transactions were domestic would not suffice to compel the conclusion that the plaintiffs' invocation of § 10(b) was appropriately domestic."). 

The opinion reasoned by negative implication, noting that Morrison never said that such factors were sufficient. It also concluded that the alternative would conflict with the determination that Section 10(b) did not have extraterritorial application.

The reasoning of the opinion is thin.  Having found that the test in Morrison could largely be disregarded, the court simply concluded that Congress, back in 1934, did not intend in a sub silentio manner to permit actions that could conflict with the laws of foreign jurisdictions.  The court relied not on citations to the legislative history or to the language of the statute but to what it viewed as an “obvious” possibility that must have been considered. 

The reasoning reflects a result oriented decision.  The court was concerned that, by allowing actions based solely on the domestic/listed nature, actions would be permitted under Section 10(b) that had few domestic implications.  Nonetheless, such an implication was hardly lost on the Supreme Court.  The Supreme Court deliberately sought to render the nature of the parties and the location of the fraudulent behavior irrelevant.  

The Second Circuit was appropriately concerned with the implications of the test set forth by the Supreme Court in Morrison.  But by implementing an effects test , the Second Circuit did so in only one direction.  By allowing consideration of the effects only for transactions that were domestic or for securities that were listed, the effects test was only used to deny the availability of Rule 10b-5.  

Nothing in the test employed by the Second Circuit suggested that it would be used to allow shareholders to bring an action under the antifraud provisions that clearly implicated US interests but did not involve a domestic transaction or listed security.  This could occur, for example, where a US shareholder bought shares in a US company and alleged fraudulent behavior that occurred in the US but was prohibited from using Section 10(b) under the Morrison framework because the sale closed outside the United States.  Yet while the Second Circuit devised a formula that would exclude actions by foreign shareholders that did not reflect a sufficient domestic interest, the court did not seek to expand the test to include actions by domestic shareholders that did have such an interest.  In short, the Second Circuit developed a reverse effects test. 

The court effectively acknowledged the almost legislative nature of the decision, suggesting that the task was more appropriately handled by Congress or the Commission.  In fact, a legislative change is sorely needed in this area.  The current test for applying Section 10(b) (the location of the transaction or the listed nature of the security) is based upon an arbitrary formula that does not reflect the domestic interests of the parties or the location of the behavior.  The decision in Porsche has made the standard even more arbitrary.  


Morrison, the Second Circuit, and the Reverse Effects Test: ParkCentral Global Hub Limited v. Porsche Automobile Holdings (Part 1)

The Supreme Court in Morrison v. National Australia Bank held that Section 10(b) of the Exchange Act (and Rule 10b-5) could not be applied in an extraterritorial fashion. In doing so, the Court overturned the longstanding "effects" test developed by the Second Circuit.  

The Court replaced the effects test with an approach that looked to whether the securities transaction at issue was domestic, that is, executed in the United States, or involved a security listed on a national stock exchange. The Court was likely unhappy with the latter test. It presumably allowed a transaction to be subject to the antifraud provisions even if it occurred outside the United States (otherwise the domestic test would subsume the standard).  

The Court was, however, stuck. The decision was driven by the plain language contingency on the Court and Section 10(b) specifically referenced stock exchanges. See Section 10(b), 15 U.S.C. 78j(b) ("To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered.").  

The result was a decision that had obvious and uncomfortable implications. First, it did not really limit Section 10(b) to domestic transactions. Irrespective of the location of the transaction, it was enough that the security was listed on a U.S. stock exchange.  

Second, by devising a test that looked only to the location of the transaction (domestic) or the nature of the security (listed), the Court rendered irrelevant the identity of the parties (domestic or foreign) or the location of the fraudulent behavior became irrelevant. As a result, U.S. citizens who bought shares of U.S. companies could not sue for fraud that occurred in the United States where the transaction fortuitously closed outside the United States (and did not involve a listed security). As we noted in a post the day that Morrison came out: 

  • the opinion indicates that in some cases, jurisdiction requires trading to occur in the United States. This means that U.S. citizens who trade in U.S. companies and allege fraud that occurred in the United States lack jurisdiction under Rule 10b-5 if they bought the shares outside of the United States. This is true even if an active (although as we will discuss, non-exchange) market exists in the United States for the same shares.  

Under the Second Circuit's "effects" test, such an action would be possible. After Morrison, it was not.

While cutting back on the right of domestic plaintiffs to bring an action under the antifraud provisions, the decision effectively expanded the right of foreign shareholders to rely on Section 10(b). Under the test in Morrison, a transaction involving foreign citizens, foreign companies, and foreign behavior could be brought in the United States if the sale happened to close in the United States. The effects test likely would have prevented this action but under the analysis in Morrison it was presumably acceptable.  

This uncomfortable and illogical result has generated considerable discomfort among the lower courts, particularly the Second Circuit. The appellate court has responded by reinstating the effects test. Only it's really a "reverse effects" test. Rather than consider the effects to determine who can bring an action, the Second Circuit has used the test to decide who cannot bring an action.   

The most recent decision in this area, ParkCentral Global Hub Limited v. Porsche Automobile Holdings, has gone the furthest in adopting a reverse effects test. The Second Circuit addressed a set of facts involving foreign plaintiffs, foreign companies, and behavior that occurred overseas. Only the transaction was inconveniently alleged to have occurred in the United States. Rather than simply apply the analysis from Morrison, the court chose to conclude that some domestic transactions were not subject to Section 10(b) based upon the effects. We will discuss the case in the next post.


Teaching Securities in Law School (Part 2) 

So what can be done differently in a securities class?  

Obviously, a class as broad as securities can be taught in an infinite number of ways.  My class has always had a section on market structure (mostly discussing the role of FINRA and broker arbitration and the stock exchanges, including the consequences of their shift to for profit companies). 

This year, however, I had students read the excerpt from Flash Boys that was published in the NYT.  The topic facilitated a discussion of market structure that at least introduced the idea of market fragmentation, high frequency trading, the national market system, dark pools and a cursory overview of some of the requirements of Regulation NMS.  Later in the semester, we will spend a day on Regulation ATS (the primary regulatory framework for dark pools) and Regulation NMS.  To the extent that more suits are brought (either by private parties or government agencies) during the semester in these areas, we will discuss them in class.

The class will also deliberately focus on Rule 10b-5 and not on Section 11 or 12 of the 1933 Act (both will, however, be mentioned).  Rule 10b-5 requires an analysis of the basics of any false disclosure claim including materiality and concepts such as completeness.  Unlike Section 11, it requires some discussion of causation, reliance and scienter.  Scienter in turn requires some discussion of the standards set out in the PSLRA. 

To make room for some of these topics, things had to be cut.  The main place that I reduced coverage was in connection with the exemtions from registration.  The SEC has studied the use of exemptions and it is quite clear that almost all exempt offerings are conducted under Rule 506 of Regulation D.  So in my class, there will be a mention of the others, but a detailed examination of an exemption will only take place with respect to Rule 506.  Of course, Rule 506 builds in many of the requirements that are relevant to the other exemptions, including accredited investors, general solicitations, and bad actor provisions. For students who want more, we offer a class on capital raising that examines the exemptions in greater detail. 

As much as I enjoy the law of insider trading (mostly because of its bizarre nature), I dropped the topic from the class this year and expanded the discussion of the proxy rules.  I added in short exercises that required students to access proxy statements and pull out shareholder proposals or compensation tables.  My thought was that every exchange traded company must distribute a proxy statement and every other public company must distribute a proxy or information statement.  As a result, students who go on to represent public companies (particularly small public companies) will likely be participating in the drafting and/or review of the proxy statement.  Greater familiarity with these rules seems useful. 

Perhaps the biggest omission from the class, in my opinion, is any serious examination of the Investment Company Act and the regulation of mutual and hedge funds.  We offer a separate class that examines regulated industries including these entities but for now they are not covered by the basic securities class.  Perhaps when I plan my course for next year, this will change.  

All of this makes it difficult to find a good textbook (I use my book on Corporate Governance mostly because it has sections on market structure, particularly the role of the exchanges, although they will need to be updated in the next version).  Nonetheless, I provide current supplemental material over TWEN.  Students read some of the releases that altered the definition of accredited investor (by excluding equity from the house) and that adopted the "reasonable steps" standard under Rule 506.

Nonetheless, this is a class that, I think, can never be taught exactly the same way twice.  But getting a correct mix that is both useful and current is not easy.  Any thoughts or comments on this would be greatly appreciated.